Earnings season for the oil majors is underway, and Royal Dutch Shell kicked things off last week, reporting fourth quarter earnings that doubled from a year earlier. The report was not entirely free of blemishes, but the performance appeared to be strong—another quarter in which profits rose, debt fell, and the overall outlook proved to be trending in the right direction.

Fourth-quarter earnings significantly missed expectations, but they do not necessarily negate the broader improving trend for the oil majors.

However, the quarterly reports from other oil majors revealed disappointment. Downstream earnings, a rare bright spot for the largest integrated companies during the oil market downturn, came in lower than expected. Chevron and ExxonMobil saw their share prices dive by more than 10 percent in two trading days, which was magnified by the broader selloff in equity markets. Taken together, fourth-quarter earnings significantly missed expectations, but they do not necessarily negate the broader improving trend for the oil majors.

Earnings miss expectations

Shell posted robust results, earning roughly $16 billion on a current cost of supply (CCS) basis, a metric similar to net profit, excluding one-time items. The Anglo-Dutch oil major also paid down its debt by $8 billion over the course of 2017, a priority after its debt reached a peak of $70 billion in 2016. The one area of disappointment was that Shell’s cash flow actually shrank from a year earlier, missing estimates.

Exxon and Chevron fared much worse. Exxon’s earnings dipped to $3.7 billion excluding one-time items, down from $3.8 billion a year earlier. On a per share basis, profits were just $0.88, a decline of two percent. Perhaps more importantly, analysts had expected earnings of $1.04 per share. The miss sent Exxon’s stock tumbling by six percent on February 2. Meanwhile, Exxon’s total oil and gas production dipped 3 percent, as the supermajor has been struggling with stagnant production for several years.

The story for Chevron was similar. The company earned just $0.72 per share—sharply lower than the $1.22-per-share estimate by the market. Chevron’s share price crashed as a result. BP’s results looked more positive in comparison, and it avoided some of the criticism that its peers received. Earnings jumped for BP as new projects came online, boosting output. Overall oil and gas production increased to 2.58 million barrels per day (Mbd) in the fourth quarter, up from 2.19 Mbd a year earlier. Earnings for the British oil giant quintupled from a year earlier, making it the most profitable quarter since 2015.

Poor quarterly numbers from some of the largest oil companies scared investors who expected a more solid performance.

Still, the oil majors have suffered steep declines in the stock market. The drop was certainly in part due to some poor timing—the global financial system sold off on Friday, February 2, dealing sharp losses across equity markets. Losses continued on Monday. But while broader financial turmoil deserves partial blame, the poor quarterly numbers from some of the largest oil companies scared investors who expected a more solid performance. “Earnings were significantly weaker than expected,” Rob Thummel, portfolio manager at Tortoise Capital Advisors, told CNBC. “That’s what’s really driven the S&P energy stocks off more significantly.” Amid the remarkable selloff on Monday, energy was one of the worst performing sectors. The S&P 500 energy sector posted its worst single-day performance in two-and-a-half years, losing 4.4 percent.

“We got carried away with our expectations, and by we, I mean Wall Street as a whole,” said Oliver Pursche, of wealth manager Bruderman Brothers LLC, according to Reuters.

Poor refining margins

A deterioration of refining margins in the fourth quarter was a major factor behind the disappointing results. Shell’s downstream earnings fell quarter-on-quarter from $2.6 billion to $1.4 billion, and BP’s profits from its downstream unit also fell, dipping from $2.3 billion to $1.5 billion (although BP reported strong figures for the full year). Chevron’s U.S. downstream earnings rose, but that was obscured by tax benefits and the lack of maintenance at its facilities in the fourth quarter. Internationally, Chevron saw its earnings from refining fall sharply, dropping to just $84 million, down from $357 million a year earlier.

A deterioration of refining margins in the fourth quarter was a major factor behind the disappointing results.

Global average refining margins shrank from $16.30 per barrel in the third quarter to $14.40 per barrel in the fourth, according to BP. That narrowed even further to $12.10 per barrel in the first few weeks of 2018. BP says that as a rule of thumb, its earnings fluctuate by $500 million for every $1-per-barrel change in the refining margin. While the figures are different for other companies, the general result is the same. Shell said it realized average margins of $8.59 per barrel in the fourth quarter along the U.S. Gulf Coast, compared to $13.04 per barrel in the third.

Integrated oil majors

During the depths of the oil market downturn, the integrated oil majors performed better than U.S. shale drillers, owing the relative success to their integrated business model. When oil prices collapsed, so did upstream earnings. For pure-play shale drillers, their balance sheets worsened. But for the oil majors, poor upstream performances were partly offset by stronger earnings from their refineries. Low oil prices stimulated global demand, widening margins.

Refining margins in key regions, such as the U.S. Gulf Coast and northwest Europe, have fallen by more than 50 percent in recent weeks.

However, the same integrated companies may miss out to some extent as prices increase. Rising oil prices brings a windfall to the shale driller, but higher upstream earnings for the oil majors are offset as refining margins are squeezed. Margins in key regions, such as the U.S. Gulf Coast and northwest Europe, have fallen by more than 50 percent in recent weeks, according to Reuters. “Margins have suffered and the biggest factor behind the weak margins we’ve seen is the run-up in crude prices,” Jonathan Leitch, research director with‎ consultancy Wood Mackenzie, told Reuters in January.

Nevertheless, the trend for the oil majors, and the rest of the oil industry, is still improving. Earnings are rising, even if they missed analysts’ expectations. Most of them foresee ongoing improvements in cash flow. “The company is operating and firing on all cylinders,” CEO Bob Dudley said in an interview with Bloomberg television. “We’re looking to generate much higher levels of free cash flow all the way through to the end of the decade and beyond.”

The improved cash flow could create more room for output growth, but the oil majors are still clear that they are favoring restraint. “We’ll have more options than I think we can afford. We’ve got a sight of projects all the way out well into the next decade,” BP’s Bob Dudley told Bloomberg. “We’ll pick them carefully. We want higher returns…It’s all about returns, not production.”

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The Fuse is an energy news and analysis site supported by Securing America’s Future Energy. The views expressed here are those of individual contributors and do not necessarily represent the views of the organization.

Issues in Focus

Safety Standards for Crude-By-Rail Shipments

A series of accidents in North America in recent years have raised concerns regarding rail shipments of crude oil. Fatal accidents in Lynchburg, Virginia, Lac-Megantic, Quebec, Fayette County, West Virginia, and (most recently) Culbertson, Montana have prompted public outcry and regulatory scrutiny.

2014 saw an all-time record of 144 oil train incidents in the U.S.—up from just one in 2009—causing a total of more than $7 million in damage.

The spate of crude-by-rail accidents has emerged from the confluence of three factors. First is the massive increase in oil movements by rail, which has increased more than three-fold since 2010. Second is the inadequate safety features of DOT-111 cars, particularly those constructed prior to 2011, which account for roughly 70 percent of tank cars on U.S. railroads. Third is the high volatility of oil produced from the Bakken and other shale formations, which makes this crude more prone towards combustion.

Of these three, rail car safety standards is the factor over which regulators can exert the most control. After months of regulatory review, on May 1, 2015, the White House and the Department of Transportation unveiled the new safety standards. The announcement also coincided with new tank car standards in Canada—a critical move, since many crude by rail shipments cross the U.S.-Canadian border. In the words DOT, the new rule:

Since the rule was announced, Republicans in Congress sought to roll back the provision calling for an advanced breaking system, following concerns from the rail industry that such an upgrade would be unnecessary and could cost billions of dollars. The advanced braking systems are required to be in place by 2021.

Democrats in Congress have argued that the new rules are insufficient to mitigate the danger. Senator Maria Cantwell (D-WA) and Senator Tammy Baldwin (D-WI) both issued statements arguing that the rules were insufficient and the timelines for safety improvements were too long.

The current industry standard car, the CPC-1232, came into usage in October 2011. These cars have half inch thick shells (marginally thicker than the DOT-111 7/16 inch shells) and advanced valves that are more resilient in the event of an accident. However, these newer cars were involved in the derailments and explosions in Virginia and West Virginia within the past year, raising questions about the validity of replacing only the DOT-111s manufactured before 2011.

Before the rule was finalized, early reports indicated that the rule submitted to the White House by the Department of Transportation has proposed a two-stage phase-out of the current fleet of railcars, focusing first on the pre-2011 cars, then the current standard CPC-1232 cars. In the final rule, DOT mandated a more aggressive timeline for retrofitting the CPC-1232 cars, imposing a deadline of April 1, 2020 for non-jacketed cars.

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DataSpotlight

The recent oil production boom in the United States, while astounding, has created a misleading narrative that the United States is no longer dependent on oil imports. Reports of surging domestic production, calls for relaxation of the crude oil export ban, labels of “Saudi America,” and the recent collapse in oil prices have created a perception that the United States has more oil than it knows what to do with.

This view is misguided. While some forecasts project that the United States could become a self-sufficient oil producer within the next decade, this remains a distant prospect. According to the April 2015 Short Term Energy Outlook, total U.S. crude oil production averaged an estimated 9.3 million barrels per day in March, while total oil demand in the country is over 19 million barrels per day.

This graphic helps illustrate the regional variations in crude oil supply and demand. North America, Europe, and Asia all run significant production deficits, with the Middle East, Africa, Latin America, and Former Soviet Union are global engines of crude oil supply.